CHAPTER 11: FINANCING INNOVATION START-UP FIRMS
Small start-up companies are key sources of new ideas and industrial innovation and, not surprisingly, are gaining prominence in the innovation system. In emerging areas where demand patterns are not settled, the technologies are not fully worked out and risks are substantial, small firms are outperforming large firms by a wide margin. Small firms have the advantage under these difficult conditions because they are decidedly more flexible, more focused and provide a better combination of incentives for fostering creativity than their larger counterparts. Clearly, a country characterized by a greater number of innovation start-ups and business success stories will gain the advantage in the knowledge-based economy and it is for this reason that the Committee will next explore the uncharted challenges facing innovation start-up companies. We will begin with their access to venture capital, followed by a review of the elements required to form a successful cluster of these extraordinary start-ups, and finish with the National Research Council’s (NRC) forays into incubating innovation spin-off companies and coordinating the development of innovation clusters in Canada.
Finance is the lifeblood of any enterprise but, for any new enterprise, it can often be the critical difference in whether and how a good idea is turned into a novel product, service or technology. Finance, which one may think is the least problematic of factors for a person with a great idea or innovation a priori, can, in the end, turn out to be the most critical factor. In fact, financial matters can be pivotal precisely because the development or sophistication of Canada’s capital markets at the venture end of the financial capital market spectrum has been found to be somewhat lacking relative to our major competitor country, the United States. One venture capitalist maintains that the current demand and supply imbalance for venture capital is precarious, if not alarming.
[T]he venture capital industry in Canada has less than one year of cash. So although it’s growing, the fact of the matter is, in my view, it’s in a perilous position because we are having these unprecedented numbers of new company start-ups and company growth and suddenly they’re going to hit a brick wall if the money isn’t there. [Calvin Stiller, Canadian Medical Discoveries Fund Inc.; 29, 9:35]
There also appears to be a regional dimension to this demand-supply imbalance:
[T]here is a severe lack of venture capital funding for new ventures, new start-ups, etc. in some regions of the country, particularly Atlantic Canada. … [T]here are opportunities there but it’s very difficult to get VCs [venture capitalists] to look at Atlantic Canada. There’s still this situation where many banks and VCs … [are] not really interested in the true start-up, which has no assets, no cash flow, except, perhaps, for IP and people. Canada has relatively few VC investors compared to the United States, though, again, that’s changed dramatically to the positive in the last three or four years. [Arthur Carty, National Research Council of Canada; 29, 9:20]
Exhibit 11.1
Source: National Research Council of Canada.
This improvement in the past few years was backed up statistically and is presented in Exhibit 11.1. Canada’s venture capitalists are financing more than ten times what they were just seven years ago and, in 1999, 80% of their investments were in new technology companies:
Field |
Investment |
Percentage |
| computer-related | $982 million |
(36%) |
| communications | $359 million |
(13%) |
| biotechnology | $315 million |
(12%) |
| electronics | $262 million |
(10%) |
| medical/health | $159 million |
(6%) |
The root cause of the problem is often stated as follows: the process of bringing new ideas to market presents more difficulties than financing an ongoing operation. The newness of the product means that the market’s acceptance is uncertain and the financial institution bringing the product to market must go to greater lengths in predicting this reception. This situation implies that the financial institution faces both more risk and a higher degree of uncertainty about the nature and magnitude of this risk compared to financing ongoing business operations. Unfortunately, the talent prepared to work at the venture capital end is scarce in Canada, and a thin supply side has led to modest government intervention. Both the Business Development Bank of Canada (BDC) and the National Research Council of Canada (NRC) are engaged in different ways in the venture capital business.
The Committee was also told that there is another side to this picture:
Often the failure of small companies is due to the fact they can’t access financing, for example, venture capital. They need very strong management skills and that’s sometimes a shortcoming in Canada. Obviously they need highly qualified resources, human resources. They need advice and mentoring. Incubation is a great help to small companies to help give them that oxygen which is so crucial to their nurturing and growth ... [Arthur Carty; 29, 9:05]
A lack of highly skilled managers in small businesses in Canada also adds to the risk the financial institution must screen for and bear when taking products to the market for the first time.
Capital markets adjust to these risky opportunities in a number of ways, most notably they specialize at the various stages in a start-up company’s development. As a result, there is differentiation among venture capitalists, a kind of "stratification of capital suppliers." Hence, the market has an order from seed capital to expansion capital to mezzanine capital to junior capital and finally to senior capital stages, whereupon a start-up company graduates out of the venture capital range and is ready to undertake an initial public offering (IPO) to one of Canada’s stock markets. Along this venture capital continuum:
Seed investment is a different type of venture capital than expansion capital. Expansion capital is different than that mezzanine, and the junior capital markets are different than the senior capital markets. Are any of them the answer? No. It’s a continuum. [Calvin Stiller; 29, 10:25]
Other strategies employed by venture capitalists include representation on the start-up company’s Board of Directors, maybe even suggesting a manager of operations, and measured financing at different stages of development.
Little amounts of money don’t work in venture capital. You can invest a small amount of money but you need to be there for future rounds. It needs to be an effort of trying to get funds in very small amounts, $200,000, $300,000, but those are just the first rounds. If it’s a successful technology, you’ll find yourself needing $2 million or $3 million just to stay with the rounds that could ultimately raise $10 million or $15 million or $20 million.
[David Mowat, Vancouver City Savings Credit Corporation; 29, 9:20]
The BDC also reports that, in their sample survey, "venture-backed companies that have gone public consumed an average of $23 million in private capital before embarking on their IPO." This survey also indicated that:
Venture capital investors have provided, on average, 37% of the total equity in the private companies …, allowing them to play a meaningful role without assuming control. The founders themselves had a substantial stake — 28% of the equity capital — directly aligning their interests with those of their investors. Corporate investors continue to play a significant role in this market, providing 24% of the equity to private companies while private investors accounted for another 6% of the total. The final 5% of equity has come from employees, governments and universities.12
There will also have to be an exit strategy for the venture capitalists upon or after the start-up’s graduation to the major stock market ranks, so we are talking about ten years of development under the wings of venture capital.
It was suggested that the tax modifications or enhancements would to some extent alleviate the demand and supply imbalance, specifically:
[T]ime honoured for developing resources in the ground over the last many decades out west was flow-through shares and it was wonderful. It wasn’t tax loss; it was tax deferral if profit didn’t come. Why we don’t do that in the area of research and development is beyond me. [Calvin Stiller; 29, 9:40]
The Committee believes the reason that the federal government appears reluctant to develop such a tax instrument has been related to the long-standing problem of defining R&D activity for tax purposes. Nevertheless, the Committee prefers the government’s current strategy of directly attacking the capital market gap through the activities of the BDC. Moreover, in many ways we are not just describing a capital supply problem but a coordination problem, which the Committee will next broach.
Innovation Clusters and the Coordination of its Elements
What comes through loud and clear from all stakeholders of Canada’s innovation system is that much success in starting up innovation or new technology companies is related to the development of innovation clusters: geographically concentrated industrial centres containing a number of elements (see Figure 3.1). Contrary to the popular myth that Canada’s business sector does not have an entrepreneurial spirit, the Committee was told that: "I take real issue with the idea that the DNA of Canadians is deficient of the entrepreneurial gene. … The Canadian genome has that entrepreneurial gene there." [Calvin Stiller; 29, 9:35] What appears to be missing is some form of integrating force or coordinating function bringing the requisite elements together.
We hear about a lot of success stories. I think if you’re looking for areas for improvement, we really still have three solitudes. We have people, there’s money, and there’s technology. In Canada, we have a pretty good supply of all of them. What we aren’t able to do often is get them together, and either get the people mentored, get the money in the right places or get the technology backed by the proper people and the proper money. [David Mowat; 29, 9:20]
Evidence of these three solitudes is found in one particularly important industry in Canada’s future, i.e. biotechnology, and the problem was described in the following way:
I was asked to speak in front of a major venture capital fund in Canada … and it was Genetics 101. They were really starting 20 years behind their counterparts in the States. That was five years ago. [Allan Bernstein; 29, 11:20]
Furthermore, evidence was found to exist in some of the more traditional sectors of Canada’s economy: the automotive sector, for one. Windsor is the centre of research in the automotive industry — at least the majority of research — which happens to be 50 to 100 kilometres from the large research centres of Michigan, where the automotive company head offices are located. Windsor is a clear strategic choice of industry, yet the NRC is proposing an additional automotive research centre be located in London, Ontario, which is more than 180 kilometres north of Windsor. So the application of the cluster strategy in the automotive sector seems to be going awry, as the various parties seem to be headed off in different directions.
Technology Transfer, Incubation and Spin-offs at the NRC
The newly or re-engineered NRC now takes what can be described as an aggressive or entrepreneurial approach to stimulate innovation in Canada. Its president listed just some of the Council’s accomplishments in this area:
In terms of NRC itself, since 1995 we have actively pursued the creation of new companies and new businesses with our intellectual property, our technology and our knowledge. You can see that this is a growing activity. We have created about 45 new companies over the last five years and about 40 of those are new startups and spinoffs … [Arthur Carty; 29, 9:05]
About 150 estimated spinoffs from government labs, including I might say, 110 from the National Research … and … there are … close to 800 university spinoffs in Canada. They generated about $2 billion in sales and about 12,000 jobs. Our own estimates of NRC spinoffs alone put it at about 7,000 employees—over a considerable period of time of course—and $1.2 billion in annual sales. [Arthur Carty; 29, 9:05]
These accomplishments flow from the NRC’s incubator program or strategy. This strategy transfers technology to industry in one of three ways (see Exhibit 11.2). The collaborative research route involves the sharing of funding and management of medium-
to long-term research with industrial partners (may involve more than one company, as well as university partners). Researchers work side by side with NRC teams. The NRC also grants industrial clients the right to exploit NRC-developed technology for a specified period and area of application. This licensing route sometimes grows out of collaborative research efforts and generally results in revenues that flow back to continue the cycle of discovery to innovation to market. However, the fastest technology transfer or commercialization method is the spin-off or start-up company route, whereby the NRC provides various forms of support — training, advice, management and financial.
Exhibit 11.2
Most of the NRC’s research institutes have the means to incubate small technology-based firms. Co-location at NRC labs contributes significantly to the process and there are more than 65 incubator tenants at the NRC today. Exhibit 11.3 displays the elements and activities of the incubation process, but it was described to the Committee in the following way:
I just show you some idea about the incubation process. Here in the middle is the company, the new start-up, the spinoff, and it needs … access to R&D, business planning, capitalization, business development. It gets synergy from other companies which are in the incubator. Of course the capital is there. There are services that can be provided, networking services for example, coaching and mentoring. This is the idea of the incubator providing the oxygen and the wherewithal for these companies to survive, to get the impetus and to grow to be medium and large companies. [Arthur Carty; 29, 9:10]
Exhibit 11.3
The Committee is overwhelmed by the entrepreneurial partnerships the NRC has forged with industry and believes that these successes, while too numerous to mention, are an intriguing and effective way of tackling the problem. With the BDC attacking the venture capital gap from the financial side and the NRC attacking it from the technology transfer side, much success is expected. Working in tandem, perhaps the BDC and NRC together could spur innovation in all regions of Canada. The Committee, therefore, recommends:
18. That the Government of Canada direct the Business Development Bank of Canada and the National Research Council of Canada to develop and implement a joint incubation/technology-transfer assistance strategy. The strategy should encourage private venture capital and labour-sponsored fund participation.